What is a Home Equity Loan, and How Does it Work?

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Home equity loans are useful for major life expenses like repairing a leaky roof, remodeling your kitchen or paying for your child’s college education. They offer low rates and terms up to 30-years which make expenses more manageable. This article will discuss the positives and negatives of a home equity loan to help you decide if it’s the right funding tool for you.

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What is a Home Equity Loan?

Home equity loans allow homeowners to borrow against the equity, or ownership, they've built up on their existing property. Like regular mortgages, home equity loans are paid out in one lump sum and often feature fixed interest rates. There are two types of home equity loans: a closed-end loan—generally referred to as a home equity loan—and an open-end loan, referred to as a home equity line of credit (HELOC). Here we focus on the pros and cons of the closed-end home equity loan.

In order to qualify for a home equity loan, you must have built up equity in your home. Typically lenders will allow you to borrow up to 90% of your home’s value, as long as your combined loan to value (CLTV) remains below that percentage. CLTV is the total amount you owe against your property divided by the total value of the property, expressed as a percentage. In addition you will also need to meet the lender’s debt-to-income and credit score requirements. A good DTI is less than 43%. A good credit score is usually over 700, but qualifications may vary by lender.

For example, if your home is paid off and worth $400,000, borrowing up to 90% of your home’s value will allow you to cash out up to $360,000 of your available equity. Alternatively, for the same $400,000 home, let's say you still owe $280,000 on your first mortgage and you've already paid off the other $120,000. If you wanted to take out a home equity loan, the most you could borrow would be $80,000. This is because the new $80,000 home equity loan, combined with your existing $280,000 mortgage makes up 90% of your home equity, or $360,000 in combined debt. This would be expressed as a 90% CLTV ratio ($360,000/$400,000) consisting of your first mortgage and your home equity loan. The CLTV factors in all debts owed against your home. The same standards apply if you have multiple home equity loans outstanding.

When deciding on a home equity loan, remember to consider the closing costs and consequences of default. Closing costs may include appraisal fees, origination fees, title fees and settlement fees. You can pay these out of pocket or roll them into the loan. Your closing documents will obligate you to make ongoing monthly payments to your lender based on your loan amount and interest rate. A default in required payments may lead your lender to initiate foreclosure proceedings, jeopardizing your homeownership.

Home Equity Loans: Pros and Cons

Home equity loans can be useful for financing major expenses or consolidating outstanding debt. Borrowers seeking to reduce their interest costs will often find that home equity loans feature significantly lower interest rates than credit cards or other unsecured loans. Consolidating these debts into a lower interest rate home equity loan can save you a significant amount of money. Additionally, rather than taking on expensive personal loans, home equity loans can be attractive, low-cost sources of borrowing for home renovations, education costs and emergency expenses.

As mentioned above, failure to repay a home-equity loan can lead to the loss of your home. You should carefully consider the overall status of your finances to reduce the risks a home equity loan may pose and ensure you can afford the payments. Keep your CLTV as low as possible to reduce the risk of market movements putting your home “under water,” where the amount you owe exceeds the value of your home, affecting your ability to sell or refinance in the future. Additionally, unless you use your home equity loan to fund home renovation costs, the interest you pay may not be tax-deductible under new tax rules in 2018.

Home equity loans are often a good choice for funding major expenses, however, they are not the only option and considering those alternatives is important to knowing what choice is right for you. Those alternatives include credit cards, unsecured loans and borrowing from a retirement account.

Home Equity Loans vs Credit Cards

If you’re looking for a flexible revolving credit product for incidental purchases that you intend to pay off within 30 days, a credit card may be more useful than a home equity loan. Credit cards provide quick unsecured financing without the threat of losing your home for failure to make required payments. They also provide borrowers with a grace period in which they incur no interest costs, as long as the balance is paid off in full every month. Responsible borrowers who avoid carrying large balances on their credit cards may also find them to be profitable, as many credit cards come with no fees and unique rewards programs that provide incentives for use.

If you’re looking to fund a large purchase that you need to repay over time, a home equity loan is a better option. Credit cards come with significantly higher interest rates; the national average for credit card rates is around 16%, whereas home equity loans are around 5.75%. The result is substantially higher interest costs when compared to home equity loans. Additionally, repeated late or missed payments will damage your credit rating and may result in unsustainable levels of debt that become increasingly difficult to repay.

Home Equity Loans vs Personal Loans

If you need a large lump sum payment quickly, want to avoid closing fees and dislike the idea of putting up your home as collateral, an unsecured personal loan could be the best option for you. Compared to home equity loans, unsecured loans are funded quickly and do not risk your home in the event of a default. However, they also feature higher interest rates, ranging between 8% and 28%, depending on the amount of money you are requesting, the term of the loan and your credit score, when compared to 5.75% on home equity loans. Unsecured loans also have shorter terms than home equity loans, usually between two and seven years, which combined with high interest rates, may make the payments unaffordable to some borrowers. However, when used for eligible home renovation expenses, home equity loans have the benefit of being tax-deductible.

Home Equity Loans vs Home Equity Lines of Credit (HELOCs)

If you have a large expense that you need to finance, but aren't sure how much it will cost, a home equity line of credit can offer flexibility when a home equity loan might be too rigid. HELOCs are revolving lines of credit with adjustable rates based on the prime rate plus a margin, similar to credit cards or personal lines of credit. As revolving credit lines, HELOCs can be used and repaid and used again during the “draw” period, which generally lasts five to 10 years; after which a repayment period begins, which usually last 10 to 20 years.

HELOCs allow you to borrow as much as you need, and only pay interest on the funds borrowed. By contrast, home equity loans provide a lump sum payment amount that you must pay interest on in its entirety. For this reason, homeowners with large complex projects, like home renovations, favor the flexibility that HELOCs offer. Both home equity loans and HELOCs are considered "second mortgages, which means that the lender has claim to your home, should you fail to repay your loan.

If you're looking for something with greater budgetary certainty than a HELOC, but less restrictive than a home equity loan, some lenders have begun offering HELOCs with fixed-rate conversion options. These are hybrid revolving products that allow you to lock in a fixed rate on a portion of your HELOC draw for a fee.

Home Equity Loans vs 401(k) Loans

Loans from your retirement account are also an option when you intend to repay the money quickly and want to avoid the closing costs associated with a home equity loan, but be aware of tax implications before taking this step. Not to be confused with a 401(k) withdrawal, which should only be used for emergency expenses, a 401(k) loan allows you to borrow from your 401(k) and repay yourself with interest over a year or two. Assuming your 401(k) plan allows it, credit qualification is less of a concern for this loan, making this a potentially viable option for individuals with poor credit. Additionally, all interest repaid is reinvested into your 401(k) account, so technically, it’s a loan to and from yourself.

Keep in mind that failure to repay this loan will result in income taxes on the outstanding balance of the loan plus a 10% early withdrawal penalty if you are younger than 59-and-a-half. Another risk is that if you leave your job with an outstanding 401(k) loan, the terms of the loan may be accelerated and due in full. You also lose out on any investment gains from leaving those funds in the account; borrowers should be wary when considering this as a borrowing option.

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Get Multiple Home Equity Offers at Once
Get Multiple Home Equity Offers at Once
LendingTree can help you find and compare home equity rates, all without affecting your credit.
LendingTree is our ultimate parent company
See Offers

on LendingTree's secure website. NMLS #1136: terms and conditions apply

Powered by
LendingTree is our ultimate parent company